New Supreme Court Ruling on GAAR

The Supreme Court of Canada released its long-awaited decision in Jordan B. Lipson, Earl Lipson v. The Queen on January 8, 2009. A majority of the Court (four of the seven judges who heard the appeal) held that the general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act (the Act) applied to deny an interest deduction on a loan that was used, indirectly, to fund the purchase of a home. The decision upheld the result in the two courts below. Two separate dissenting judgments were delivered.

The majority's ruling on the applicability of GAAR is quite narrowly focused on the particular facts in issue and on the taxpayers' reliance on the "attribution rules" in the Act. The decision does not appear to change significantly the basic framework for the analysis of when GAAR applies, as established by the Supreme Court in its 2005 decisions in Canada Trustco and Kaulius. Nor should the decision be taken to establish broader principles that would have major implications for tax planning not involving the use of the attribution rules.

Facts

Mr. Lipson and his wife had agreed to buy a house from an arm's length vendor. The day before the purchase closed, Mrs. Lipson borrowed approximately $560,000 from a bank (the first loan) and used these funds to buy shares of a private family investment corporation (LipsonCo) from her husband. Mr. Lipson then used the $560,000 proceeds to complete the purchase of the home. Title was registered jointly.

The following day, another loan (the second loan) for $560,000 was obtained from the same bank, secured by a mortgage on the house. The proceeds of the second loan were used to repay the first loan.

LipsonCo paid dividends to Mrs. Lipson for each of the three years that were reassessed. In two of those years, the interest expense on the second loan exceeded the dividends received by Mrs. Lipson, resulting in a loss. In one year, the dividends exceeded the interest expense, resulting in net income.

The Canada Revenue Agency (CRA) did not challenge the $560,000 selling price of Mr. Lipson's shares of LipsonCo as not reflecting fair market value. Although the adjusted cost base of his shares is not revealed in the decisions, there was likely an accrued capital gain.

Legislation

Several provisions of the Act were relevant to the Lipsons' planning:

• Paragraph 20(1)(c) provides that a taxpayer may deduct interest expense on money borrowed to acquire an income-producing asset.
• Subsection 20(3) provides that when a taxpayer uses borrowed money to repay money previously borrowed, the borrowed money is deemed to have been used for the purpose for which the money previously borrowed was used.
• Subsection 74.1(1) attributes income or losses on transferred property from a transferee spouse to a transferor spouse.
• Subsection 73(1) provides for an automatic rollover when one spouse transfers property to another spouse, unless the transferor spouse elects out of the rollover pursuant to paragraph 74.5(1)(c). If the transferor spouse chooses to make this election:
  • any accrued capital gain in the transferred property is triggered on the transfer (i.e., the spousal rollover does not apply); but
  • attribution of income, losses, capital gains or capital losses from the transferee spouse to the transferor spouse is prevented.
• The subsection 73(1) spousal rollover applies even when the transferor spouse receives cash consideration on the transfer - a unique feature of the spousal rollover.

Mr. Lipson's Position

Mr. and Mrs. Lipson filed their tax returns on the basis that the second loan was deemed by subsection 20(3) to have been used for the same purpose as the first loan (i.e. to purchase an income-earning property (the LipsonCo shares)). Accordingly, the interest expense on the second loan was deductible by Mrs. Lipson pursuant to subparagraph 20(1)(c). They also took the position that, because Mr. Lipson had not elected out of the rollover, Mrs. Lipson's losses from the transferred shares (for the two years in which her interest expense exceeded the dividends received) and her net income from the shares (for the one year in which the dividends received exceeded her interest expense) were attributed to Mr. Lipson under the attribution rules.

The CRA's Position

The CRA reassessed on the grounds that GAAR applied to deny the interest deduction to Mrs. Lipson. The result was that Mrs. Lipson's gross income (i.e. the dividends) was attributed to Mr. Lipson, rather than her net income or loss (i.e. after deducting the interest expense).

The CRA did not attempt to apply subsection 74.5(11), an anti-avoidance provision within the attribution rules. It provides that the attribution rules do not apply when it may reasonably be concluded that one of the main reasons for a property transfer that is otherwise subject to the attribution rules is to reduce the amount of tax that would be payable on the income and gains derived from the property. If the CRA had applied this provision instead of GAAR, the interest expense would have been deductible against the dividend income received -- but in Mrs. Lipson's hands, rather than Mr. Lipson's.

The result of the reassessments, therefore, was that neither Mr. Lipson nor Mrs. Lipson could deduct the interest expense. The CRA asserted that GAAR should apply because the purpose of the series of transactions was to borrow money to purchase the house, not to acquire the shares.

The Issue

Mr. Lipson admitted that there had been a "tax benefit" and an "avoidance transaction," but argued that GAAR could not apply because the requirement in subsection 245(4) was not fulfilled. That provision states that GAAR can be applied only if it may reasonably be considered that the transaction in question would result directly or indirectly in a misuse of the provisions of the Act or in an abuse having regard to the provisions of the Act read as a whole. It was up to the Courts to make this determination.

Lower Court Decisions

The Minister of National Revenue was successful in both the Tax Court (2006 DTC 2687) and the Federal Court of Appeal (2007 DTC 5172). In the Tax Court decision, Chief Justice Bowman (now retired from the Tax Court, but the judge who had ruled against Mr. Singleton at the Tax Court level in John R. Singleton v. The Queen (96 DTC 1850)) held that the series of transactions resulted in a misuse of all the provisions relied on, because they were carried out for the purpose of making interest deductible on borrowed money used to buy a residence.

The Federal Court of Appeal upheld this decision, finding that the Tax Court judge was entitled to take into account the purpose of the series of transactions in determining whether any of the transactions in the series resulted in an abuse.

The Supreme Court of Canada Decision

The majority of the Supreme Court held that to allow the attribution rules to operate to reduce Mr. Lipson's income by allowing him the benefit of the interest deduction would be an abuse of those rules and that GAAR should therefore apply.

The reasons for the majority's decision are important. The decision states that if Mr. Lipson had simply sold shares of LipsonCo to his wife and she had claimed an interest deduction on money borrowed to acquire those shares, the plan would have worked. The provisions of paragraph 20(1)(c) and subsection 20(3) had not been misused or abused at that point.

However, the transactions became objectionable when the Lipsons turned to subsections 73(1) (the spousal rollover) and 74.1(1) (the attribution rule) to obtain the result of shifting the interest deduction to Mr. Lipson. To allow subsection 74.1(1) to be used to reduce Mr. Lipson's income tax from what it would have been without the transfer of shares to his wife would frustrate the purpose of the attribution rules, and GAAR was thus properly invoked by the Minister. The decision characterizes the attribution rules as, themselves, anti-avoidance rules, which were being used to facilitate abusive tax avoidance.

Fort the most part, the majority applied the GAAR guidelines as established in the Supreme Court's previous GAAR decisions in reaching the conclusion that the benefit of the attribution of Mrs. Lipson's interest expense could be denied to Mr. Lipson under GAAR because to allow him this deduction would frustrate the object, spirit or purpose of these provisions.

Curiously, although the Minister had approached the assessment by disallowing the interest deduction altogether, and simply adding the gross dividends on the LipsonCo shares held by Mrs. Lipson to Mr. Lipson's income, the Supreme Court ruled that, even though the dividends should continue to be attributed to Mr. Lipson, the interest deduction should be allowed to Mrs. Lipson. For taxpayers in her situation who have other income sources, the allowance of the interest deduction to the spouse is welcome. The Minister's failure to convince the majority to deny the interest deduction to both Mr. and Mrs. Lipson can therefore be considered a significant loss on a central part of the Minister's case.

Upholding the assessment of the dividends in the hands of Mr. Lipson but indicating that Mrs. Lipson should be allowed the interest deduction seems to be inconsistent with the conclusion that GAAR should apply because the attribution rules had been misused. With all due respect, if the attribution rules were frustrated if they operated to attribute the interest expense to Mr. Lipson, then a more consistent recharacterization of the tax consequences would have been to leave both the dividends and the interest in the hands of Mrs. Lipson.

This result could have been achieved by invoking the specific anti-avoidance rule contained within the attribution rules, subsection 74.5(11). However, the Minister had not based the reassessment on this provision and both parties had agreed for purposes of the appeal that its application was not in issue. The argument was advanced that the Court should refuse to apply GAAR given that there was another, more specific anti-avoidance rule. The majority refused to consider whether the taxpayers could have succeeded under that rule. The majority clearly held that GAAR is a residual provision that can apply even if the transaction falls outside the scope of a more specific anti-avoidance provision. In other words, the fact that a specific anti-avoidance rule exists is not conclusive that transactions not within the scope of that rule are not subject to scrutiny under GAAR. 

In the Singleton case, the court held that planning by an individual to convert non-deductible interest expense on a home mortgage into deductible interest expense was acceptable. In that case, Mr. Singleton, a lawyer, withdrew capital from his law firm and used the capital to acquire a house. On the same day, he borrowed from a bank to replace the capital in his firm. While the Tax Court of Canada ruled against him, both the Federal Court of Appeal and the Supreme Court of Canada held that he could rely on paragraph 20(1)(c) to deduct the interest expense, as the borrowing was directly traceable to the replacement of the capital. However, Singleton was not a GAAR case.

The Lipsons' planning had similarities to the steps taken by Mr. Singleton, the only differentiating factors being that two taxpayers (spouses) rather than one, were involved in the Lipson planning, and that the attribution rules were also a factor.

Therefore, the question remains whether planning of the type in Singleton is still acceptable. In argument at the Supreme Court of Canada, the Crown in Singleton conceded that it did not claim that GAAR would have applied on the facts of that case. In his dissenting judgment in Lipson, Binnie J. (Deschamps J. concurring) clearly assumed that the Singleton planning would not be found to be subject to GAAR, and concluded that the Lipson planning, which he characterized as Singleton with a "spousal twist," similarly should not be found to be abusive tax avoidance. He could not reconcile the majority's conclusion that the interest deduction per se was not abusive, with its conclusion that the plan became abusive with the addition of a spousal rollover that operated precisely as Parliament intended.

In the majority reasons, LeBel J. sidestepped the question of whether the Singleton case is relevant to Lipson by noting that neither GAAR nor the attribution rules was at issue in Singleton. He also stated that applying paragraph 20(1)(c) and its direct use test involves an inquiry that is distinct from those that must be made under section 245 (GAAR). Although the Court was urged to find for Lipson on the basis that to find otherwise would introduce undesirable uncertainty into tax planning, the majority decision states that uncertainty is inherent, because the GAAR analysis always requires consideration of the unique facts. It is designed to restrain abusive tax avoidance.

The second dissenting opinion was delivered by Rothstein J., who agreed with the reasoning of the majority and of Binnie J. that GAAR did not apply with respect to the use of paragraph 20(1)(c) and subsection 20(3). (Note that Rothstein J. had, while on the Federal Court of Appeal, written the majority decision in Singleton, in favour of Mr. Singleton.)  However, Rothstein J.'s conclusion that GAAR did not apply in respect of the use of the attribution rules was based on his view that the plan should have been found to fail because of the specific anti-avoidance rule contained in subsection 74.5(11). Rothstein J. noted that if the Minister had applied this rule, the result would have been different because both the dividends and the interest would have remained with Mrs. Lipson rather than being attributed to Mr. Lipson. In Rothstein J.'s view, the Minister should only resort to GAAR when there is no other recourse. In this case, the proper recourse should have been to subsection 74.5(11). The view that it was open to the Court to base its conclusion on subsection 74.5(11) applying was rejected by the other members of the Court.

Implications?

It is difficult to state what has been added to the jurisprudence on GAAR by this decision, not least because of the division in the Court and the unusual number of opinions.

The CRA has indicated on past occasions that, following the release of the decision in Lipson, it might have to revisit its position on the Singleton-type planning, and other types of planning techniques, such as "cash damming," a technique that today is endorsed as acceptable in Interpretation Bulletin IT-533 (Interest Deductibility and Related Issues).

It does not appear that the Lipson decision justifies any change in the CRA's previously established positions set out in IT-533 and elsewhere. Nothing in the majority decision deals with the type of planning undertaken in Singleton, which involved a single taxpayer arranging his affairs to maximize interest deductibility. The majority reasons in Lipson make it clear that the narrow focus of the analysis, and the reason for concluding that GAAR applied, was the introduction of the attribution rules into the planning. Both dissenting judgments are emphatic that planning to finance personal assets out of equity and income earning assets out of borrowed funds is acceptable tax planning. Nothing in the majority decision contradicts this.